Economic Inflection Points

Every once in awhile we witness a convergence of issues that create an economic inflection point……….a point which we change direction. Although the concept of an inflection point stems from calculus, it is applicable the current economic situation. It seems safe to say that our current direction seems to be lateral; we are basically stuck in a holding pattern while we grapple with the weight of significant debt (government, corporate, mortgage, personal, etc.), depressed consumer confidence and a prevailing sense of caution. Economic indicators generally seem to be in a holding pattern and recovery seems tepid at best.

Where do we go from here?

Let’s detail the issues and make some assumptions;

QE 2: Expired this morning. While bond yields trended down significantly over the last two months, they have increased significantly this week (over 30 bps). The question being asked is did QE 2 work, and what will happen to the treasury market without the Fed being a big buyer.

European Debt Crises: The Greek government passed austerity measures yesterday, and seems to have met the criteria for significant IMF aid. Portugal, Italy, Ireland and Spain still seem problematic.

Japanese Production: This week witnessed an encouraging increase in Japanese production numbers, but energy constraints will curtail a rapid recovery from the earthquake and tsunami related damage.

Arab Spring: The NATO intervention in Libya continues, as does repression in Syria, Yemen and other Arab nations. The potential for disruption to oil flows remain, although the willingness to tap into strategic oil reserves appears to have mitigated the problem.

US Debt Ceiling: The August 2nd deadline nears without any clear willingness to compromise on the part of either political party.

Unemployment: Continues to be stuck at a maddeningly high rate of near 9%

Dodd-Frank Regulatory Reform: The rule making is bogged down, resulting in a continued lack of clarity for lending institutions. Loans to small business and mortgage underwriting remain tight.

Chinese Inflation: The Chinese banking system has raised rates four times this year, and the government keeps raising capital and reserve requirements for its lending institutions.

Upon first review of the above, one might pause and wonder if the Mayans were a year too late in their prediction of the world’s demise. However, if one looks at the incredible resiliency being shown by the world’s economies despite the above issues, hope for improvement seems logical. There is an incredible amount of capital ready to be deployed in the US economy. Rule making under Dodd-Frank has taken a turn towards a more rational approach as testimony and comments have provided regulators with an increasing awareness of what constitutes practical reform. We should witness some clarity by year end, and 2012 will see an environment where lenders understand the rules of the game and make loans with some financial certitude. Debt ceiling resolution and a long term strategy to achieve a more balanced budget will occur. This morning, the US Senate announced that it was canceling the week long July 4th vacation so that it could engage the budget resolution debates in earnest. The President seems to have focused on the problem, and golf games aside, the dialog between Republicans and Democrats will increasingly be more focused on compromise and less on ideology. Personally, I think QE 2 was necessary and that it worked. Personal opinions aside, rates will be much more dependent on budget resolution than the continued participation of the Fed in the treasury market. There are plenty of buyers for US treasuries…..as long as the full faith and credit of the US continues to mean something.

The Arab Spring will ultimately be beneficial as this part of the world desperately needs more open economies. It will be awhile before demonstrations and unrest subside, but the willingness to tap the strategic oil reserve has mitigated the economic impact of the problem. Oil will trade between $90 to $100 per barrel and gas prices should stabilize between $3.50 to $4 per gallon. The Chinese tightening credit is ultimately good for everyone, but it will slow down their growth. Coupled with the Japanese situation, it will result in Asia joining Europe and North America in slower paced economic growth.

Finally, unemployment will be a problem for the next three years. It will come down, but slowly. Economic growth will be in the 2.5 to 3.5% range over the next three years, and unemployment will trend down to a more historical rate by 2015.

So, how does all this add up to an inflection point?

This writer has come to believe that our collective ability to grow despite numerous challenging events bodes well for improvement over the next three to five years. Yes, there are issues to be resolved, and yes there are other threats that could emerge, but the world has enough synergistic growth that we are no longer as vulnerable to unsettling issues. There is a growing confidence that the world economy is now truly a “World” economy, and that the result is that emerging market demand and capital accumulation in the developed nations will result in sustainable economic growth. We are at a point in time that will prove this thesis.